Investors Focusing on Fundamentals in New Year to Prepare for Wider Range of Potential Outcomes

Investors Focusing on Fundamentals in New Year to Prepare for Wider Range of Potential Outcomes

Most Financial Services Firms Maintain Optimistic Outlook for US Capital Markets in 2018, but Also Advising Note of Caution

Investors and lenders are expected to closely monitor property fundamentals in the markets and property sectors they invest in for 2018 as the U.S. economy continues its extended recovery now heading into its 10th year.

Despite record low unemployment, increased consumer confidence and a strong stock market, many in the industry see slower growth ahead for rent increases, property prices and overall demand for commercial space. As the capital market moves later into the current real estate cycle, financial services firms are maintaining an optimistic outlook for the U.S. economy, although many are also recommending a cautious approach.

S&P Global Ratings, for example, does not expect a steep correction in real estate prices in the New Year, but is forecasting modest price pressure given slowing fundamentals in light of lower economic growth than in previous years.

There are other risks that could develop, S&P added, that could potentially cause a steeper correction in real estate values, including capital market volatility from a steep equity market correction or sudden spike in interest rates. In addition, bank exposure to CRE is at peak levels and a significant reduction in loan originations could dampen valuations.

In its outlook for 2018, LaSalle Investment Management refers to a Goldilocks environment, in which investors should look for an investment that is neither too ‘hot’ nor too ‘cold’ driven by balanced fundamentals and steady pricing.

LaSalle is expecting debt for real estate to remain plentiful in 2018. At the same time, it expects lenders will continue to tighten their underwriting, especially for specific sectors that become “overheated.”

Over the course of the year, Morgan Stanley noted that larger banks of more than $20 billion in assets tightened their lending standard much more than smaller banks. Multifamily loans had the greatest increase in net tightening and loan demand declined more in that category more than others in 2017.

On the positive side, LaSalle expects less hurdles for the major lending sectors in 2018 after the market overcame several potential obstacles in 2017, including the maturity of 2007 vintage loans, CMBS risk retention and Fed oversight of bank real estate.

As 2017 progressed, it became clear that risk retention wasn’t going to be a major market impediment, and issuance increased as the year went on, according to Kroll Bond Ratings Agency (KBRA). Transaction sizes, however, largely remained under $1 billion, which was partially attributable to risk retention that forced a number of originators to exit the market, as well as the size of the CMBS investor base.

On the up side of peaking property this year, KBRA noted, is that single borrower refinancing deals should continue to thrive as borrowers look to lock-in gains from property value increases. Borrowers may also want to lock in rates the Federal Reserve sending signals that more rate increases are to come in 2018.

As always, job growth will be a critical driver of real estate demand. And to the extent that the recently passed tax legislation that slashed corporate rates spurs additional business investment and hiring works as intended, job growth could exceed expectations.

“We’re now confronting a wider range of possible outcomes for the economy, depending on how various initiatives such as federal policy changes play out,” said Spencer Levy, CBRE Americas head of research and senior economic advisor, who added that agility will be more important than ever for investors this year.

Investors should shift to focusing on income gains rather than appreciation as their primary source of returns as cap rates flatten out or, in some cases, start to rise, Levy noted.

Potential Strategies for Office, Industrial, Retail Investing

Major U.S. office markets are on the verge of a cyclical tipping point, with new construction and softening demand mirroring the evolution of previous CRE cycles, Moody’s Investors Service reported.

And while the markets may be hoping the supply-and-demand cycle plays out differently this time, that isn’t likely, Moody’s noted.

“New office construction is ramping up in many major U.S. cities, so that by the end of next year new inventory will be coming online at roughly double the rate of the past three years, while at the same time the growth of office-using employment will be slowing,” said Kevin Fagan, a Moody’s vice president and senior analyst.

As we enter 2018, there is 154.5 million square feet of new office space under construction, according to CoStar data. That compares to 97.8 million square feet delivered in 2017.

While the amount of office construction is increasing, the 252 million square feet delivered last year or under construction is still one-third lower than the 381 million square feet delivered in 2006 and 2007 when CRE markets last peaked.

Similar to the office market, new supply is also running high in the industrial property sector going into 2018 with 318.1 million square feet under construction following 311.6 million square feet delivered last year.

The big difference compared to office is that demand remains very robust for both bulk warehouse and closer-in delivery hubs as e-commerce continues to reshape and boost demand for distribution space. This positions the industrial market to perform well in 2018, although risks would escalate should economic growth slow, according to LaSalle.

While E-commerce is boosting the industrial investment potential, the retail sector continues to bear the brunt from lower traffic and sales. Construction of new retail space continues to decline with just 86 million square feet under construction at the beginning of 2018, well down from the 103.6 million square feet of retail space delivered last year.

Investors see exceptions within the sector, however. Grocery-anchored retail space in well-located centers remains in demand as reflected in the strong capital market activity at these centers that we believe will continue, according to LaSalle.

CBRE sees retailers and investors gravitating to either the discount and off-price sectors or luxury. This may create weakness, and, in many cases, investment opportunities, in secondary and suburban markets.